Bargains best left in the basement

How to tell a cheaply priced value stock from a 'value trap'

SAN FRANCISCO (MarketWatch) -- Most veteran value investors have a story about the stock they wished they had let get away. The shares looked attractive and the company's worst troubles seemed behind it. But instead of a quick fix, they got quicksand; the stock languished, a waste of money and time.

For John Linehan, manager of the T. Rowe Price Value Fund
TRVLX, +0.54%
such disillusionment comes from a stake in Boston Scientific Corp.
BSX, +0.97%
The medical device company appeared to have healthy demand for its products and its costs were under control, he says, but tough competition and an expensive acquisition of heart-device maker Guidant has proved otherwise.

"It's been death by a thousand cuts," Linehan says of the investment. "I would love not to look at that in my portfolio. It just hasn't worked."

Still, Linehan is not without hope. "The responsible thing to do is look at the valuation, what it could be worth. There's still a lot of opportunity for them to cut expenses."

Bargain hunters have done well in recent years as buyers have been able to identify cheaply priced companies poised to rebound. But as the bull market runs longer, investors face the problem of falling into "value traps," where cheap-looking stocks stay cheap -- indefinitely.

Unmarked trails

The trouble with value traps is that, like bear markets, you don't really know you're in one until you're in one. But there are some telltale warning signs.

"A value trap is defined by disappointing fundamentals rather than a disappointing stock price," says Bill Nygren, manager of the Oakmark Fund
OAKMX, +0.31%
"It's one of the risks of value investing. Over time the stock-price chart and your estimates of business value end up being parallel downward sloping lines. The stock keeps getting cheaper and the outlook keeps getting worse."

"The stocks are cheap for a reason," adds Savita Subramanian, a Merrill Lynch & Co. strategist who flags suspect companies and industries in a monthly "Value Trap Alert." "Value investors buy them and get burned. It's safer to wait until there are some signs of life."

Investors in cyclical industries that rise and fall with the economy are particularly exposed to value traps. Their challenge is determining if a company's misfortune is temporary or reflects protracted problems with the business itself.

"You have to differentiate between two types of value traps," says Whitney Tilson, co-manager of the Tilson Focus Fund
TILFX
There's the "dead money" value trap, he says, where a sound, growing company lacks a catalyst to move its stagnant stock price. And the second, gloomier trap: a declining industry with deteriorating market share.

"Sometimes it's hard to tell if there's a permanent impairment of capital or it's time to increase your investment," Tilson says.

"A lot of people think Wal-Mart is a permanently impaired business," he adds. The stock
WMT, -0.37%
traded at around $49 two years ago, he notes, and hovers there now.

"We think they've just made some mistakes," he says. "It reminds us very much of McDonald's four or five years ago."

Back then, Tilson invested in McDonald's Corp.
MCD, +0.67%
with the stock in the low teens and many on Wall Street writing the iconic restaurant chain's epitaph.

"We concluded that McDonald's was not a value trap," Tilson recalls. So he more than doubled his stake in the company, he says; the shares now trade at around $52.

Business sectors can become fertile ground for value traps and that scenario would currently include newspapers, says Mr. Nygren, the Oakmark Fund manager.

The newspaper industry's "operating income isn't growing and the stocks look cheap relative to historical acquisition values, but on a forward look they just get a little bit worse every year," he says.

Sidestepping pitfalls

While value traps can be difficult to spot, many investors have learned the hard way that vigilance and experience are two strong defenses against these money pits.

"Look for companies that have a competitive advantage, where it appears likely that the business will be worth substantially more in five years than it is today," adds Nygren. "If we don't believe it's likely that the business will have growth that at least matches what we expect for the market, we'll pass on it."

Nygren has been a strong believer in Home Depot Inc.
HD, +0.65%
for instance, even though the home-improvement retailer's shares trade at a lower price than they did in 2001.

If you look at the stock price, you would think something is really wrong with the business, Nygren says. "In reality, the company earns twice as much money as it did six years ago when the stock was much higher."

Is a stock a value, or a potential value trap? Linehan suggests looking at five factors:

The business should boast strong free-cash flow, which provides a margin for error, along with a solid balance sheet and high quality assets. Investors should try to determine if an industry is in a short-term cyclical downturn or longer-term secular one, then mesh that view with detailed, fundamental knowledge of the company.

Says Linehan: "If you focus on the quality of the balance sheet and the quality of the assets, you've got more ways of winning."

There's a sixth consideration, Linehan says: "Understand that you're not going to get one through five right all the time. Sometimes you just have to have the patience to wait it out."

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